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China is becoming middle aged, so it’s slowing down a bit

In some ways, the rise of China has been too good to be true. Its economy has grown with breakneck speed for decades (an average of 9.1% a year since 1994, with a lowest rate of 6%) – if we can believe the official accounts.

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The Chinese authorities have recently begun to preach the need for a gradual rebalancing, making China less dependent on export growth and increasing domestic consumption. The country also wants to develop greater social security for its 1.3 billion people. Nevertheless, the growth target remains a hefty 7.5%.

After the Lehman crisis the Chinese authorities successfully prevented a sharp downturn, at the cost of a sharp build-up of debt. In 2014 the economy was struggling once again and the authorities quietly stimulated the economy, fuelled once again by a strong growth of credit. Estimates differ about the current level of debt as a percentage of GDP, but the trend is clear: the debt binge is far from over. You might well compare the country to someone in middle age who is still enjoying the good life, fuelled by credit, but has started to slow down a bit, and is looking for better balance in their life along with a social safety net.

‘Quiet stimulus’ has been preferred

Does this mean that China is on the brink of a financial crisis caused for example by a property crash, followed by a string of corporate defaults? I don’t think this is very likely, although these fears are widespread and to a certain extent understandable. The theme of a ‘hard landing’ has been around for years. It has also been pointed out that the rise of the most successful capitalist economy of the 20th century, the United States, was interrupted by the Great Depression and then World War Two, so we should not expect China’s meteoric rise to go on smoothly forever.

And indeed, it has not done so: after a mini-stimulus earlier this year, Chinese growth up until now has still been slightly disappointing. In 2014, China injected a massive USD 80 bln into the five largest banks, equivalent to a 50 basis point rate cut. Chinese leaders sought to assure everyone that they’re not preparing a massive stimulus package, while hinting that they could live with an undershooting of the Chinese growth target of 7.5%. Market participants have since lowered their forecasts of Chinese growth towards 7.0%. On the other hand, Chinese leaders won’t accept a sharp weakening momentum of the economy because of the risks to employment and social stability that this would imply. Their preferred course of action is what I would call ‘quiet stimulus’ of this kind.

Chinese growth up until now has still been slightly disappointing

Easy to avoid a hard landing …

Meanwhile, the Chinese economy still has important structural advantages to avoid a hard landing. For instance, it has a low dependency on foreign debt (around 10% of GDP) combined with impressive foreign reserves amounting to around 40% of GDP, or USD 4 trillion. The external sector is therefore an unlikely trigger for a crisis. Furthermore, the domestic debt load is to a large extent a consequence of state-owned banks lending money to state-owned companies.

And so the Chinese government can easily prevent a credit crunch by forcing banks to continue lending, particularly through the shadow banking sector. Known officially as ‘non-bank intermediation’, this sector has more than tripled in size since 2008, albeit from a low base. As a consequence, shadow banking in China is relatively low both as a share of GDP and of financial intermediation. Central government debt is low, so it can absorb a lot of problems if it chooses to do so. A bond default – once unthinkable – has already been accepted. So the overall debt ratio is likely to continue to rise in the coming years as policymakers give priority to growth.

… but China can’t defy gravity forever

In the long run, the Chinese growth rate cannot defy gravity forever – it has to come down at some point. The economy is still heavily dependent on investment, which in 2013 was the largest contributor to growth. Gross domestic investment was a staggering 47% of GDP. However, some of these huge investments will most likely be unprofitable and will have to be written off. The current rate of investment is unsustainable over the long term, and will likely give way to higher domestic consumption.

As national savings accounted for a staggering 49% of GDP in 2014, probably mainly due to the lack of a social safety net, there is ample room for increasing consumption. Compensating for the inevitable slowdown in investments with a comparable increase in consumption won’t be that easy to engineer and could easily trigger a recession.

Of course, events could take a different course, in which the Chinese authorities willingly let things slide. They could decide to bite the bullet after futile warnings for years that the debt dependency inherent in the economy is unsustainable. They could decide to curb debt growth decisively and let things run out of hand after a series of policy mistakes. This isn’t very likely, but it’s also not unthinkable.

So what would be the likely consequences for the world economy if Chinese growth did plunge to zero? As China is the world’s second-largest economy, amounting to around 10% of world GDP on a purchasing power parity basis, a severe slowdown would be felt worldwide. It would mean a negative global demand shock, initially shaving 0.75% from world GDP growth.

China could decide to curb debt growth decisively

Four victims of a struggling China

There would be four main victims of this. First, the largest trading partners of China (as observed from China’s import side) would see their exports decline. These partners are in order of magnitude: the EU, Japan, South Korea, Taiwan and the US, who between then account for 47% of Chinese imports. OPEC would also take a knock as it is a major exporter of oil and petroleum products to China.

Second, as China is a major commodities importer, a collapse of Chinese growth would probably mean a collapse in commodity prices, exacerbating deflationary trends in the world economy. From an investor’s point of view this would increase the flight to safe haven bonds such as German Bunds and US Treasuries. It would be bad news for emerging markets equities and probably equities in general.

Third, from a regional point of view, a massive slowdown would be especially bad news for the rest of the Asia Pacific region. Problems could be exacerbated if the Chinese authorities try to counter the lack of growth with a sharp depreciation of the yuan. Military tensions could also rise markedly if the Chinese authorities were to attempt to deflect domestic public anger by using confrontational action against countries labelled as external ‘aggressors’, such as Japan, with whom it has a long-running dispute over island ownership in the South China Sea.

Fourth, a hard-up China could be tempted or forced to dump a significant part of its huge stock of US Treasuries, provoking a sharp rise in US long-term interest rates, damaging the world economy further. A sharp deceleration of Chinese growth could therefore turn into a major earthquake, hitting the world economy, eventually pushing it into a recession.

Other countries need to sort themselves out

But don’t worry just yet. China’s main priority over the next five years is to rebalance its economy and improve the quality of its social safety net, and I think it will succeed in doing so nicely. The real problem will be faced by exporters to a country that has been insatiable up until now. A gradually slowing growth rate in China, which is far more likely, would clearly lower import demand and thus lower export volumes from other emerging markets to China, preventing a decent rise in their current accounts.

So I expect at least some countries to counter this by addressing the supply side problems in their economies, making them more competitive in the global market and preventing cost push inflation and social unrest. Current account deficits in emerging markets are still significant from a historical perspective and a further adjustment process could require further depreciation of currencies in the medium term. The Chinese economic miracle – and its knock-on effects – ain’t over yet.

Léon Cornelissen , November 2014

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